Income annuities are a great way for retirees to get guaranteed income for life, but there’s room for improvement in the way they are taxed. In an earlier blog, I outlined how they are currently taxed, and that while the rules are fair they don’t generate the personal and societal benefits they could.

Taxes raise money for government operations, but they also sometimes serve to change behavior in society. Taxes on cigarettes are a well-known example because they encourage smokers to quit, especially when the taxes approach the cost of a pack. Society further benefits from a reduction in health-related costs.

I propose a tax cut that would provide retirees with more spendable (after-tax) income and change financial behavior. That would encourage them to convert their savings into a reliable stream of lifetime income, which in turn would help them be less reliant on government programs. It would be a win-win. (They might also save more for retirement if they saw a more secure future.)

In addition, the tax cut could reduce the federal deficit. Really! But before we discuss how a tax cut can increase tax revenues, let’s describe how retirees get their boost in income.

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Boost income for current and future retirees

Many retirees are necessarily conservative in their investments in retirement, since they don’t have new savings to make up for any losses when markets decline, nor time to wait for a recovery. Those conservative investments, like bond mutual funds and CDs, earn less than stocks over the long run, but carry less risk.

What people really need in retirement is more money, not less.

Here is what I would suggest to help retirees generate more income by changing their behavior: Encourage retirees to allocate a part of their retirement savings to income annuities by changing the taxation of annuity payments to make them more attractive.

Here’s what happens under current law.

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A male retiree who is 70 years old might decide to put, say, 50%, of his $500,000 rollover IRA account in conservative fixed investments earning an average of 3% per year. That $250,000 would produce around $10,000 in required minimum distributions at age 70½, growing to $13,000 at age 85 — all of which would be taxed as ordinary income.

In contrast, if that retiree rolled over the same $250,000 of IRA savings to an income annuity, he would receive around $20,000 in annual annuity payments for life. While he’s taking on the risk of survival (see earlier article for more on longevity risk), if he went the annuity route — as opposed to the IRA route above — he would have a taxable income that’s $10,000 higher at age 70 ($20,000 for the annuity vs. $10,000 for the IRA). His taxable income would be $7,000 higher at age 85 ($20,000 for the annuity vs. $13,000 for the IRA).

A decrease in taxes on the income from the annuity would promote annuitization and give retirees more money to pay for things like late-in-life expenses, including unreimbursed health care costs.

The concept would work for retirees. The next step is convincing legislators that this would also be good for the overall economy.

The four benefits the government would receive

Benefit No. 1: The government would generate as much or more revenue by encouraging annuitization. (Calculation Note 1 below shows the impact of one possible tax cut.)

Benefit No. 2: Retirees would have more money to spend, stimulating the economy.

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Benefit No. 4: Increasing spendable retirement income would reduce pressure on social programs — especially Medicaid, which supports long-term care, and Social Security.

Regarding No. 4, retirees with more income, for example, might be able to afford in-home care and stay in their residences. They also might choose to put off Social Security payments until they are 70, which delays cash outflow from the system.

Why and how government should specifically favor annuitization

The tax authorities do this already in other areas. For example, by granting life insurance favorable treatment, death benefit proceeds are received income tax-free. Long-term care benefits are also income tax-free, again to encourage insuring against a critical risk. Longevity is another actuarial risk that society will pay for one way or another.

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As we discussed in a previous article, annuity payments reflect the risk-sharing benefit in the form of a longevity credit. In my view the portion of each annuity payment coming from the longevity credit should not be taxed.

A simple way to provide the tax break for the purchase of longevity insurance might be to exclude a percentage, perhaps 25%, of the taxable annuitized income from tax. A more complex formula might be required, but I’ll leave that up to the staff drafting the legislation.

To make sure this tax break is not abused, the 25% exclusion could be capped per individual so that only a certain amount of annuitized income is eligible for the tax break.

And the tax break could be provided for any form of annuitized income, including those offered through corporate or government pension plans, as well as income annuities offered by insurance companies.

What else does it take for this win-win to happen?

Retirees often are reluctant to put part of their savings into annuitized income. They imagine the stock market will produce more money, or they are afraid to bet on their own longevity.

A tax break on annuitized income might persuade more retirees to consider an alternative that would benefit them – and U.S. coffers. Of course, there would need to be education around annuitization, and planning tools that let individuals and their advisers integrate income annuities into their retirement portfolio.

Calculation Note 1: While the average tax rate under this proposal for a typical retiree with $250,000 of conservatively invested retirement savings might fall from 20% to 12% in the first year, the retiree’s income would be $3,800 higher and the IRS revenue would be $70 higher. If a proportion of, say, 100,000 retirees made the income annuity election, tax revenues would increase by $94 million over 20 years, and retiree income would be up over $5.5 billion. Calculations are based on a proprietary Go2Income model and depend on assumptions made by Golden Retirement.

Visit Go2Income for more information about annuities and how you can increase your retirement income. Feel free to contact me at Ask Jerry with questions.

Jerry Golden is the founder and CEO of Golden Retirement Advisors Inc. He specializes in helping consumers create retirement plans that provide income that cannot be outlived. Find out more at Go2income.com, where consumers can explore all types of income annuity options, anonymously and at no cost.